BusinessWeek shows you just how financial folk can rip you off: the Bear Stearns example

BusinessWeek has a fantastic piece of reporting, which is jaw-dropping in its detail, about two hedge funds at Bear Stearns which imploded with the credit crunch – in many ways, which set off the credit crunch – and the amazing misplaced confidence that its chief showed.

Always assuming it was just misplaced confidence, Not anything else.

Here’s the article. (Or, the print version on one page.) Now, a hedge fund takes money from clients, then puts it about in ways that will make more money. And for that, they charge fees: 20% of profits and 2% of the actual money staked. Sorry, invested. No, I mean “under management”.

The names of the funds? “Bear Stearns High-Grade Structured Credit Strategies fund” and “High-Grade Structured Credit Strategies Enhanced Leverage fund”. Sounds copper-bottomed, right? In fact, these were funds which borrowed against any assets they had on the most astronomic scale:

[Ralph] Cioffi [who set up and ran the funds] also used a type of short-term debt to borrow billions more; in some cases he managed to buy $60 worth of securities for every $1 of investors’ money. But he made a critical trade-off: For lower interest rates, he gave lenders the right to demand immediate repayment.

This was trading in stuff like collateralised debt obligations – CDOs – which are basically slices of lots of mortgages and other debts. You hope they’ll keep paying in the long term. But actually they’re just a “dumber investor” strategy. CDOs with high yields are likely to come from debts which aren’t likely to survive over the long term. Such as mortgages to people with rubbish credit records, to whom you sell mortgages which start low but then reset to much higher levels. They’ll either abandon the mortgage or sell out of it, and that’s that part of the CDO blown; its bond element stops working. (No doubt that’s factored in to CDOs, but they got the numbers wayyy wrong. There was misselling up and down the chain.)

As the accountants for the company, Deloitte, said on its 2006 accounts, about one-third of the “assets” were actually just thumb-in-the-air guesses by the funds’ managers.

Except of course that’s not how they put it.

Deloitte warned that a high percentage of net assets at both funds were being valued using estimates provided by Cioffi’s management team “in the absence of readily ascertainable market values.” Deloitte went on to caution: “These values may differ from the values that would have been used had a ready market for these investments existed, and the differences could be material.” In the case of the High-Grade fund, 70% of its net assets, or $616 million, were being valued in such a manner, up from just 25% in 2004. For the Enhanced fund, 63% of net assets, or $589 million, were “fair valued.”

Jeez, where’s the Plain English campaign when you need it? Not that seeing that (likely well-buried) warning would have helped; the report on the 2006 accounts didn’t come out until May 2007, by which time the funds were already on the way down.

What’s amazing, reading the story, is how this worked like some sort of con trick. You set the fund up with some quick borrowing (from Barclays, which retained the right to call it all in any time it liked; no doubt it had some vigorish on the proceedings). You hustle – sorry, carefully select – some rich people to invest in the funds. You hustle – sorry, negotiate – with some people to buy or sell some sort of lumped-together who-knows-what load of financial stuff. And don’t worry about a market downturn – won’t happen. You use that to borrow more.

It’s a house of cards. Politicians and financiers worry that people don’t have enough trust in the stock market and financial institutions? That we put too much into property? When you have banks and credit card companies charging absurd amounts with questionable legality for being “overdrawn”, and financiers who’ll sell you stuff because they’ll get a commission for years to come even while your investment doesn’t pay back even what you put in, and people like Ralph Cioffi can run vehicles called things like the “High-Grade Structured Credit Strategies Enhanced Leverage fund” (which just calls out for a bit of deconstruction, eh?), then damn right we aren’t going to trust financial institutions. You have to earn trust. These people aren’t even trying.


  1. Benjamin Graham (the 1930s Dean of Wall Street who taught Warren Buffett about value investing) wrote a wonderful book, which he updated every five years throughout his lifetime (there’s been an update since he died in the 1970s by…someone), called The Intelligent Investor, which is still more than worth reading. He espouses many common-sense principles that Buffett has since expanded upon. Most relevantly: don’t invest in things you don’t understand. As Graham says, “Bright young men have been promising to work miracles with other people’s money since time immemorial.”

    It sounds like this particular fund’s commission structure was “reassuringly expensive”. There are a lot of opportunities that open up to rich people, and I suspect strongly that the apparent “exclusiveness” of some of them is part of their appeal – if it’s expensive and only a select band of people can participate, it must be really *good*, right?


  2. While people believe there’s a fast buck to be made, there will be people who will take their money and pretend to make it happen.

    The trouble is that this includes the upper management of large finance houses. They seem as befuddled by the plans of their ‘superstar’ fund managers as the people expected to buy into these schemes.

    The question that lingers with me is whether Cioffi was as confused by his plan as they were – was he a rogue trader who knew that buying into illiquid investments allowed him to hide their true value for as long as possible or just way out of his depth on the way from bond salesman to hedge fund manager?